The Financial Conduct Authority has recently announced a consultation on new rules and guidance to reduce the potential problems faced by those who invest in open-ended funds that hold illiquid assets. These issues tend to be particularly relevant at times of extreme market stress, such as after the UK referendum on EU membership when a number of property funds had to suspend dealing after being inundated by clients wishing to sell.
Open-ended structure is not suited to holding illiquid assets
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There are various measures that could help to improve the situation, but the simple truth is that the open-ended structure is not suited to holding illiquid assets. If a fund is forced to sell some of its portfolio to satisfy a high volume of client redemptions when there are few willing buyers, it would badly affect the performance, as would having to run a significant cash buffer.
There are no such problems with investment companies and the broker Canaccord Genuity has recently looked at the advantages of using these closed-ended vehicles to gain exposure to UK commercial property. Their three key findings are:
- The average direct property exposure level of investment companies is 131% of NAV versus 78% for the largest open-ended funds. This is due to the fact that investment companies can use gearing (i.e. borrow money to invest) while open-ended funds typically run a cash buffer to ensure that they can meet client redemptions.
- The average dividend yield of UK commercial property investment companies is 5.3% versus an average of 3.0% for the heavyweight open-ended funds.
- Over the 10 years to 30th September 2018, the average annualised NAV and shareholder total returns for investment companies are 7.0% and 10.9% respectively versus 4.3% for UK commercial property open-ended funds.
Intensive asset management could be the key to generating superior performance
The consensus forecast returns for commercial property over the next few years are quite modest with income being the main driver. In view of this, Canaccord believe that intensive asset management could be the key to generating superior performance, which is why they recommend the Ediston Property Investment Company (LON:EPIC) in recognition of its depth of resources and entrepreneurial style. EPIC has total assets of £290 million and is trading at a discount to NAV of 5.1% with a yield of 5.3%.
Another option is the Schroder Real Estate Investment Trust (LON:SREI), which has recently been endorsed by Numis. The managers mainly invest in properties in ‘winning cities’, which are cities that are expected to experience higher levels of GDP, employment and population growth than the national average. These include places such as Reading, Manchester, Bristol and Milton Keynes, with the idea being that assets in these locations can improve over time.
The management team also aims to add value by comprehensively refurbishing the properties and/or achieving change of use and additional planning permission. SREI has a forecast annualised yield of 4.4% and is trading on a wider than normal discount to NAV of 11.7%, which could provide an attractive entry point for long-term investors. It has total assets of £497 million.